Question

How do forward markets reflect expectations of future spot rate? How do spot and forward markets align with interest rate and expected inflation differentials? What is uncovered interest arbitrage? Can balance of payments dynamics explain exchange rate movements?

Answer 1

The spot rate & forward rate differ from each other. In forward market, the currency may either become strong or become week, one currency may be at premium in the forward market in comparison to the spot market and the other currency may be at the discount, the percentage of forward premium or discount can be computed as follows:-

Forward Premium /discount on currency =  

(Forward Rate- Spot rate) / Spot rate * 12 month/period of forward rate *100

The forward and spot rate differential ( i.e. forward premium and discount and interest rate differential in 2 country currency should be in parity or equilibrium as per interest parity theorem.

Detail Analysis

The country having high rate of interest will attract foreign investor, of country having low rate of interest which will increase the inflow of foreign currency in the spot market. These investor will convert their currency at spot rate and invest the proceed at high rate of interest.

The principal and interest earned desired to be taken by such foreign investor back to their home. theirby requiring the foreign investor to book forward foreign exchange contract and thus increase the demand of foreign currency in forward market thereby increasing its value.

Hence, it can be concluded that Spot and Forward market align with interest rate and expected inflation differentials.

Uncovered interest arbitrage is an arbitrage trading strategy whereby an investor can get benefit on the interest rate differential between two countries

Balance of payment factor affect the determination Foreign exchange fluctuation.

If export in the country is more than the import made in the country then home currency of such country will be strong against its trading partners and import made in the country are more than the export made from the country, the home currency will be week against it trading partners.